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Strong Showing for Bond Funds Since December Rate Increase

With the Fed considering raising the interest rate again this year, Morningstar's Sarah Bush explains how it could affect different bond categories.

Jeremy Glaser: From Morningstar I'm Jeremy Glaser. As the market considers that the Fed is going to raise rates at all this year, I'm sitting down with Sarah Bush, she's director of fixed income strategies at Morningstar's manager research group, to look at how rising rates could affect different types of bond funds.

Sarah, thanks so much for joining me.

Sarah Bush: Thanks for having me.

Glaser: So this feels little bit like deja vu, about this time last year we're having the same conversation, more about if the Fed was going to raise rates for the first time. Now we are seeing if they are going to do it for the second time in this cycle. So in that year, what's happened, how have bond funds performed?

Bush: So actually bond funds have done, really, really well, since mid-December, and obviously we have been having those conversations all year as the Fed approaches its next meeting--are they going to raise this time? But through that all bond funds have prospered. We've seen the riskiest funds do particularly well. So EM local currency funds, which were really badly beaten up in 2015, are up something like 14% over the period. The hard currency funds that are more dollar-denominated have also done well. We've seen strong performance from long-term bond funds, and that's because we've really seen a rally in yields. So yields have actually come down across the yield curve and especially at the long end of the curve. So long-term bond funds have done well and we've seen an incredible rally in high yield.

So really we've seen strong performance in a lot of different places. One thing that I think is important when you think about the Fed raising rates and the impact on the funds that a lot of the people hold, is that the Fed is really acting at the very short end of the yield curve. So, what they do is definitely having an impact on short-term bonds, short-term bond yields, and people are taking those expectations about what the Fed are going to do into account when they are thinking about valuations across the yield curve, longer maturity bonds. But there is no guarantee that the two are going to move in lockstep. So we've actually seen again really strong rally in like the 10-year Treasury, it's backed up a little bit sort of through the first few weeks of September, but its done very well.

Glaser: So looking at the September meeting or maybe more likely the December meeting, how are bond managers positioning their portfolios? What are their thoughts about the potential of a rate increase?

Bush: Sure. So if you look at the fed futures market. It's not looking super likely, or the market doesn't seem to be pricing in a high likelihood of a hike in September. But you are still looking at something like 50% chance in December. That pretty much lines up as well with what we are hearing from bond managers. We had a discussion with Jerome Schneider in a video recently in the last month or so, and he's definitely thinking about that and the potential impact on the short end of the curve. So PIMCO is being very cautious about that short-term maturities and potential for volatility if and when the Fed does hike. I think that's broadly in line with how shops like BlackRock are also thinking about it, they have been talking about the expectations. There is a reasonable probability that we are going to get a hike this year.

What's also interesting though, and again, to kind of go to what does that mean for the rest of the market, I think people are expecting the Fed's activity to be relatively gradual and that they are not going to top out at very high rates. And similarly expectations out the curve are still very much lower for longer. There are a couple, there are some contrarian views out there, Michael Hasenstab at Franklin Templeton has been concerned and raised concerns at our conference actually about the potential for a significant increase in rates, but mostly I think people--sanguine is probably the wrong word but--aren't concerned that we are going to see just a huge increase in yields.

Glaser: So you are not seeing big changes in portfolios, either taking duration down, to very, very short time periods.

Bush: I think people are being careful about the short part of the curve that's most directly affected by Fed action.

Glaser: So looking across different types of bond funds investors might hold, which are going to be the most susceptible, we talked about short-term bonds. What else should you have on your radar in terms of being impacted?

Bush: Right. So in general the longer term a bond fund is, the more interest-rate risk it carries. So long-term bond funds are very volatile, because as long-term rates go up and down they get pretty significantly affected, but there again the question is what's going to happen to that long end of the yield curve, it's not an obvious answer. At the short end when you are looking at short-term bond funds those are kind of the ones that are most impacted by Federal Reserve actions, but these are less interest-rate sensitive funds anyway. So I think there is a little bit less concern there.

My colleague Eric Jacobson actually wrote article for back in November where he looked at what has been the historical experience for investors in intermediate-term funds. That's where a lot of investors have their core bond fund money when we have seen a fed rate hike cycle. And what he found was it actually hasn't been very bad, there have been short term periods of pain, but in general investors have done reasonably well and of course then once yields start to rise you are getting the benefit of that.

Glaser: How about high yield, I know that's been a popular category.

Bush: So high yield, I think that sort of conventional wisdom is that if the economy is doing well and that's why the Fed is raising interest rates that high yield should do well because those companies should do well as the economy is doing well. It will be interesting to see what happens this time because the flip side of that is as rates go up, high-yield companies have to pay more money for their borrowing. Because these are already highly leveraged companies and the economy is doing OK, but not doing great. There is some concern that potentially you could see some stress on those types of companies.

Glaser: So with the potential for a higher rates, even if there are slow high rates, is this the time to kind of abandon bonds or we have to basically, have already seen the appreciation we are going to see and that maybe it makes sense to be in cash or make sense to skew a bond allocation?

Bush: I think if you are comfortable with your asset allocation you should stay there. I mean certainly bond funds can experience losses over short time periods. So you shouldn't be using your intermediate-term bond fund for cash, for very short time period. But beyond that I think people need to think about why are they using their bond funds. Bond funds still provide really valuable diversification relative to the rest of the equity-heavy portfolio. It's very difficult to time markets, right? So, we've been talking about should you get out of bonds and into cash, we've been getting those questions since 2010 or 2011. If you were sitting in cash over that time period, you would have given up pretty phenomenal returns in the fixed-income markets. Then finally I just think we got to keep hammering home that when bond yields start to rise that will start to offset any losses in bond funds and ultimately be a good thing for bond investors.

Glaser: Sarah, thank you so much.

Bush: Thanks for having me.

Glaser: From Morningstar I'm Jeremy Glaser. Thanks for watching.